Fairfax 2023

[petec]

15 hours ago, jfan said:

Would this not suggest that their combined ratio should remain sub 100% for more than a few years

 

Absolutely. I think they are socking away significant future reserve releases at this point. Combined with rising long rates, I think we are locking in several years' worth of nice operating earnings, and I am bullish on the portfolio.

[MMM20]

9 hours ago, petec said:

 

Sure - we are certainly not at the point of speculative excess yet. But the psychological pendulum has swung a long way from the pessimistic extremes. Maybe it's halfway through its swing. And it's closer to the point where you need things to go right to win, rather than things just not to go wrong.

 

All I think Parsad and I are saying is that this is not as easy a buy as it was at the lows, and a lot more is in the price, and as it continues to rise, we should all get more cautious not more excited.

Doesn’t this come down to how much of the improvement in earnings power is structural vs cyclical? It seems like FFH has taken pricing and share as many others have been semi-permanently(?) weakened. If true, the stock may be cheaper now than back then. Like, maybe the range of outcomes was super wide ~2-3 years ago before rates and weather related losses spiked, and now we’re on an upside path in that decision tree. Does that makes sense?
 

And looking at competitors and the supply/demand dynamics, it seems like we might still be in the early days of an insurance supercycle (at least in some pockets) in which demand constantly outstrips supply due to a confluence of factors including weather/climate losses, migration patterns, ESG(?) and regulation warding off new entrants, the impact of higher rates on balance sheets and capital formation, etc. Famous last words, I know… not my base case.

 

Knowing what we know now, with all the commentary we are seeing from various management teams, macro and micro factors — would it be shocking if pricing in certain big pockets ~1.5-2x’d (and well ahead of expected losses) over the next ~5 years, generating a whole lot more negative cost float… and oh yeah, coincident with investment income spiking higher?
 

This is just a hypothesis and doesn’t need to be true for us to do very well from this price... maybe just one truly lollapalooza returns scenario. And I am not in the insurance biz so looking for more insider views on how this compares to prior cycles as of now.

 

Edited August 23, 2023 by MMM20

[Viking]

7 hours ago, petec said:

 

Sure - we are certainly not at the point of speculative excess yet. But the psychological pendulum has swung a long way from the pessimistic extremes. Maybe it's halfway through its swing. And it's closer to the point where you need things to go right to win, rather than things just not to go wrong.

 

All I think Parsad and I are saying is that this is not as easy a buy as it was at the lows, and a lot more is in the price, and as it continues to rise, we should all get more cautious not more excited.

@petec So you are saying psychology and price should drive an investors decision? Yes, a few people on this board are optimistic on Fairfax. And the stock price has gone up a lot. But really?
 

I think facts should be the primary driver of an investors decision. What are earnings going to be? What is their quality? How durable are they? How good is the management team at capital allocation? 
 

Fairfax trades at a PE of 5.2. The earnings are high quality (mostly operating) and durable. The management team has been best in class ofr the past 5 years in terms of capital allocation. Those are the facts.
 

The stock trading at a 5.2PE suggests to me that investors in Fairfax are still VERY bearish. Yes, there are a few people posting positive things about Fairfax on this board - that is a tiny sample size. Go survey the institutional guys - my guess is they are still very bearish on Fairfax (and underweight with their holdings). 
 

People are seriously arguing that Fairfax should trade at a 5.2PE because it will be earning too much over the next 3 years? The stock needs to be penalized because it is earning too much? I am sorry, that is crazy talk. You penalize a stock because it is underperforming. Fairfax really is becoming the Rodney Dangerfield of insurance.

 

If other insurance companies were trading at a 5PE i would get it. Every other quality insurance company trades at a PE of at least 10 and most are higher. Fairfax is the clear outlier. And based on the facts, that makes no sense to me. 

 

 

Edited August 23, 2023 by Viking

[Munger_Disciple]

7 hours ago, petec said:

 

Does FFH publish under GAAP anywhere? I assume not...

 

No, FFH doesn't publish GAAP book (sadly). But they did get a jump up in book value per share of roughly $100 not that long ago, so I am using that as the difference between IFRS and GAAP book values.

[Parsad]

10 hours ago, petec said:

 

Sure - we are certainly not at the point of speculative excess yet. But the psychological pendulum has swung a long way from the pessimistic extremes. Maybe it's halfway through its swing. And it's closer to the point where you need things to go right to win, rather than things just not to go wrong.

 

All I think Parsad and I are saying is that this is not as easy a buy as it was at the lows, and a lot more is in the price, and as it continues to rise, we should all get more cautious not more excited.

 

+1!  Cheers!

[Parsad]

6 hours ago, MMM20 said:

Doesn’t this come down to how much of the improvement in earnings power is structural vs cyclical? It seems like FFH has taken pricing and share as many others have been semi-permanently(?) weakened. If true, the stock may be cheaper now than back then. Like, maybe the range of outcomes was super wide ~2-3 years ago before rates and weather related losses spiked, and now we’re on an upside path in that decision tree. Does that makes sense?
 

And looking at competitors and the supply/demand dynamics, it seems like we might still be in the early days of an insurance supercycle (at least in some pockets) in which demand constantly outstrips supply due to a confluence of factors including weather/climate losses, migration patterns, ESG(?) and regulation warding off new entrants, the impact of higher rates on balance sheets and capital formation, etc. Famous last words, I know… not my base case.

 

Knowing what we know now, with all the commentary we are seeing from various management teams, macro and micro factors — would it be shocking if pricing in certain big pockets ~1.5-2x’d (and well ahead of expected losses) over the next ~5 years, generating a whole lot more negative cost float… and oh yeah, coincident with investment income spiking higher?
 

This is just a hypothesis and doesn’t need to be true for us to do very well from this price... maybe just one truly lollapalooza returns scenario. And I am not in the insurance biz so looking for more insider views on how this compares to prior cycles as of now.

 

 

This is just too much work!  I would rather wait for something else to get dirt cheap and just buy that.  Structural changes could lead to higher returns and justify a higher valuation, but this starts to get into "six-foot, seven-foot hurdle" territory.  I have no advantage and my estimate of margin of safety could be VERY wrong!  Cheers!

[Thrifty3000]

When thinking about FFH's longer term EPS potential I have to frame it more like...

 

Over the next 10 years will average annual EPS exceed:

• $100 USD (almost certainly)
• $150 USD (likely)
• $200 USD (possibly)

I think we can safely assume the "normalized" earning power of the business is currently in the neighborhood of $100 to $150 per share.

 

Working for us we have roughly:

• $2,500 of Investments Per Share
• $1,000 of Insurance Premiums Per Share

Slap a reasonable ROI on those investments, a reasonable CR on those premiums, and assume a reasonable growth rate over time, and FFH easily earns an average of $150+ annually per share over the next decade.

 

Now, what can we expect over the next decade for earnings and growth? Well, Prem gave us his version of guidance on each of these things in his annual letter. He provided charts of FFH's key historical trends, explained that profitable growth has always been in FFH's DNA, and argued we should expect profitable growth going forward.

 

In the 2 charts attached and in his accompanying commentary Prem essentially laid out the most important guiderails for investor assumptions:

• ROI on the investment portfolio will likely fall somewhere between 2.3% and 11%, and Prem believes the miserable days of 2.3% ROI are well behind us.
• Combined ratios will likely fall between 96% and 114%, and Prem believes the last 17 years of sub-100% CRs are more indicative of likely future performance.
• Revenue will grow, as it has in every 10 year period since 1985, almost certainly by no less than 50% and very likely by more than 100%. (I will be surprised if premiums aren't at least $50 billion a decade from now.)

Reasonable Assumptions?

 

After reviewing the historical charts and reading the annual report would it be unreasonable to assume normalized:

• 5% ROI on Investment Portfolio = $125 per share
• 97.5% Combined Ratio = $25 per share
• 7% annual growth
• $150 USD of normalized annual per share earning power growing to $300 USD per share by 2033.

I don't think it's that hard to make the case that those assumptions are too conservative, and I think @Viking and Prem are doing a good job of making that case.

 

 

Edited August 24, 2023 by Thrifty3000

[SafetyinNumbers]

50 minutes ago, Thrifty3000 said:

When thinking about FFH's longer term EPS potential I have to frame it more like...

 

Over the next 10 years will average annual EPS exceed:

• $100 USD (almost certainly)
• $150 USD (likely)
• $200 USD (possibly)

I think we can safely assume the "normalized" earnings power of the business is currently in the neighborhood of $100 to $150 per share.

 

Working for us we have roughly:

• $2,500 of Investments Per Share
• $1,000 of Insurance Premiums Per Share

Slap a reasonable ROI on those investments, a reasonable CR on those premiums, and assume a reasonable growth rate over time, and FFH easily earns $150+ annually per share over the next decade.

 

Now, what can we expect over the next decade for earnings and growth? Well, Prem gave us his version of guidance on each of these things in his annual letter. He provided charts of FFH's key historical trends, explained that profitable growth has always been in FFH's DNA, and to expect profitable growth going forward.

 

In the 2 charts attached and in his accompanying commentary Prem essentially laid out the most important guiderails for investor assumptions:

• ROI on the investment portfolio will likely fall somewhere between 2.3% and 11%, and Prem believes the miserable days of 2.3% ROI are well behind us.
• Combined ratios will likely fall between 96% and 114%, and Prem believes the last 17 years of sub-100% CRs are more indicative of likely future performance.
• Revenue will grow, as it has in every 10 year period since 1985, almost certainly by no less than 50% and very likely by more than 100%. (I will be surprised if premiums aren't at least $50 billion a decade from now.)

Reasonable Assumptions?

 

After reviewing the historical charts and reading the annual report would it be unreasonable to assume normalized:

• 5% ROI on Investment Portfolio = $125 per share
• 97.5% Combined Ratio = $25 per share
• 7% annual growth
• $150 USD of normalized annual per share earnings power growing to $300 USD per share by 2033.

I don't think it's that hard to make the case that those assumptions are too conservative, and I think @Viking and Prem are doing a good job of making that case.

 

 

Excellent post Thrifty3000.

 

I’m trying to get people to appreciate how big the right tail could be if one of the biggest unconstrained investors in the world gets to keep reinvesting $3b+ in profits every year in one of the most inefficient markets ever. It could get even bigger if valuation gets aggressive as momentum and index huggers try to keep up allowing the company to raise equity at silly multiples. ROE’s could be 20%+ for a period of time. The narratives will of course be different but the book value growth will be real. I think the odds are decent given the high float to market cap, the expectation of lower interest rates, the high float to book value ratio and the cheap equity portfolio.

[MMM20]

23 hours ago, Parsad said:

 

This is just too much work!  I would rather wait for something else to get dirt cheap and just buy that.  Structural changes could lead to higher returns and justify a higher valuation, but this starts to get into "six-foot, seven-foot hurdle" territory.  I have no advantage and my estimate of margin of safety could be VERY wrong!  Cheers!

 

Not sure I agree that it's not worth thinking through the scenarios, but I hear you and appreciate the good reminder that "[to] invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework." - The Intelligent Investor

 

I did just make a lunch bet with a friend on FFH vs AMZN over the next 5 years. EPS growth should be similar but maybe FFH valuation expands ~3x while AMZN's contracts ~3x. We'll see.

 

My best guess is FFH valuation expands over the next few years as higher earnings power translates to sharp growth in per share accounting book value... b/c it trades on book value.

 

The bottom line IMHO is there is a completely reasonable case to be made that FFH earnings power doubles and valuation triples over that timeframe. Still, I get the skepticism!

 

Edited August 24, 2023 by MMM20

[Luca]

11 minutes ago, MMM20 said:

I did just make a lunch bet with a friend on FFH vs AMZN over the next 5 years. I'm thinking EPS growth will be similar and FFH valuation will expand ~3x while AMZN's will contract ~3x. We'll see.

Yep, terminal multiple can ruin returns on a good growing business if bought too high. 1x Book doesn't seem egregious at all for FFH and still a strong buy considering the tailwinds etc. DCFs for Amazon, Alphabet etc make sense with a 25x exit multiple but 13-15x looks a lot worse. 

 

Edited August 24, 2023 by Luca

[UK]

On 8/23/2023 at 10:05 PM, Parsad said:

 

This is just too much work!  I would rather wait for something else to get dirt cheap and just buy that.  Structural changes could lead to higher returns and justify a higher valuation, but this starts to get into "six-foot, seven-foot hurdle" territory.  I have no advantage and my estimate of margin of safety could be VERY wrong!  Cheers!

 

Not to derail the thread, but since I recently tried to look at it: does M seems somehow a lower hurdle for you vs FFH, even at current prices? I may be very wrong on M, no strong opinion on it, but especially for a big and surer bet, I actually think it is the opposite, meaning why even bother with M, if FFH is still so cheap?*

 

 *initially was questioning something similar about META vs GOOG a year ago:)

 

Edited August 25, 2023 by UK

[Thrifty3000]

By gum, I think I'm starting to see eye to eye with @Viking on this argument that FFH is selling for around 5X normal earnings - and not 5X temporary hard-market-induced inflated earnings!

 

Here is what the current investment portfolio would look like with very conservative ROI estimates for each asset class (ie. 1% ROI on cash instead of today's 5%). Notice that even with conservative ROI estimates the contribution per share would be $116.

 

[Thrifty3000]

Now, if we fast forward to 2027, and project a scenario where the hard market has cooled and short term interest rates have moderated, we could easily be looking at something more like this (I simply increased each asset class by a total of 15% to account for 3 years of conservative growth, and I reduced the share count a bit)...

 

4 years from now, after the cliff of locked in near term interest rates has past us by, the portfolio will still be able to produce $140+ per share without needing to do anything spectacular from an investment standpoint!

 

You can add, say, $10 to $50 per share for insurance underwriting profits and we really are looking at the normalized 20% returns @Viking has been proclaiming. And, again, the all star investment team barely has to show up to work to produce the kinds of returns I'm forecasting. These estimates are probably too conservative.

[treasurehunt]

8 hours ago, Thrifty3000 said:

Now, if we fast forward to 2027, and project a scenario where the hard market has cooled and short term interest rates have moderated, we could easily be looking at something more like this (I simply increased each asset class by a total of 15% to account for 3 years of conservative growth, and I reduced the share count a bit)...

 

4 years from now, after the cliff of locked in near term interest rates has past us by, the portfolio will still be able to produce $140+ per share without needing to do anything spectacular from an investment standpoint!

 

You can add, say, $10 to $50 per share for insurance underwriting profits and we really are looking at the normalized 20% returns @Viking has been proclaiming. And, again, the all star investment team barely has to show up to work to produce the kinds of returns I'm forecasting. These estimates are probably too conservative.

 

 

Nice analysis. Thanks.

 

To calculate the final return to common shareholders, however, shouldn't you deduct interest expenses, corporate overhead, income taxes and non-controlling interests? After all that, your base case looks more like $100 EPS attributable to common.

 

[Haryana]

23 minutes ago, treasurehunt said:

 

Nice analysis. Thanks.

 

To calculate the final return to common shareholders, however, shouldn't you deduct interest expenses, corporate overhead, income taxes and non-controlling interests? After all that, your base case looks more like $100 EPS attributable to common.

 

Not Thrifty3000 here but let me take a shot at it for now and see if that hits or makes any sense to you or anyone present -

 

Apparently that table is talking about only the investment portfolio. The expenses you mentioned are reasonably projected to be more than well covered by their underwriting operations and still have profits left over to be added on the bottom line. Income taxes would be significant but still the normalized earnings are surprisingly quite high with conservative assumption.

 

[treasurehunt]

16 minutes ago, Haryana said:

Not Thrifty3000 here but let me take a shot at it for now and see if that hits or makes any sense to you or anyone present -

 

Apparently that table is talking about only the investment portfolio. The expenses you mentioned are reasonably projected to be more than well covered by their underwriting operations and still have profits left over to be added on the bottom line. Income taxes would be significant but still the normalized earnings are surprisingly quite high with conservative assumption.

 

 

Fair enough. Thrifty3000 mentioned $10 to $50 in underwriting profits. I took the midpoint and added $30 to his base investment case to get about $170 in investment returns + underwriting profits. I think this will get whittled down to $100 after all expenses and taxes.

 

But it may be that the investment base case and/or the underwriting profit estimate are on the conservative side.

[Haryana]

How wildfires are affecting some of Canada’s largest P&C insurers

https://www.canadianunderwriter.ca/catastrophes/how-wildfires-are-impacting-some-of-canadas-largest-pc-insurers-1004236933/

"

Despite facing a heavy loss year and an unusually active wildfire season, four of Canada’s publicly traded P&C companies — Intact Financial Corporation, Fairfax Financial Holdings, Definity Financial Corporation and Trisura Group Ltd. — reported positive underwriting profits thus far, according to commentary from DBRS Morningstar. 

Overall, the insurance companies reported positive net earnings for the first half — and second quarter — of 2023, thanks to consistent premium rate increases, less-volatile financial markets and higher interest rates, DBRS said. 

However, of the four companies, Intact’s results were negatively affected by higher-than-expected NatCat claims.

"

 

[Haryana]

Looking forward to Fairfax getting included in TSX60 index sometime in the next few years by replacing the Intact Financial.

 

Just for some context and seeking to be corrected if wrong:

 

TSX60 is expected to be comprised of the 60 largest Canadian companies. However, it is a bit more complicated than that.

 

To allow for diversification and representation of different industries, companies with lower market caps are included if they represent a different industry that would otherwise be missed. Thus, Fairfax is excluded from the TSX60 even if it is about the 35th largest Canadian company by market cap. Market cap of Intact is about 25B, Fairfax should overtake that soon.

 

[Haryana]

(Previous report by DBRS Morningstar attached.)

 

"

Despite suffering insured catastrophe losses of $3.1 billion in 2022, which was the third most costly year
on record, the Canadian P&C insurance industry reported a strong combined ratio well below 90%
during the year. Although there was a slight deterioration in underwriting results when compared to the
prior year, Canadian insurers benefitted from an advantageous pricing environment, contributing to solid
topline growth. Their overall results were also positively affected by favourable prior year claims reserve
developments following conservative loss estimates during the peak of the Coronavirus Disease (COVID-
19) pandemic.
Nonetheless, the Canadian P&C industry is incorporating new loss trends due to natural catastrophes
into their pricing strategies, and we expect premiums to continue the upward trend in parallel with a
hardened international reinsurance market. As Canada experiences more intense and frequent extreme-
weather events, the challenge is that certain zones of the country might become too expensive to insure
against natural catastrophes, or become uninsurable altogether.

"

DBRS415537.pdf

[Parsad]

17 hours ago, UK said:

 

Not to derail the thread, but since I recently tried to look at it: does M seems somehow a lower hurdle for you vs FFH, even at current prices? I may be very wrong on M, no strong opinion on it, but especially for a big and surer bet, I actually think it is the opposite, meaning why even bother with M, if FFH is still so cheap?*

 

 *initially was questioning something similar about META vs GOOG a year ago:)

 

 

At today's prices, if I liquidate FFH, even with higher fair value prices for the insurance subs, I might get 1-1.2 times book after paying off the debt...at best!

 

If I liquidated Macy's today, just the store in Herald Square alone is worth more than the entire company.  So forget the retail brick and mortar business, forget the online Macy's business, forget Bloomingdales, forget BlueMercury.  Just selling the real estate will pay off the debt and get me what the market value of the company is. 

 

Then if you look at it from a P/E basis...at current prices, I would get my money back from FFH in 8-10 years...whereas even with the lower earnings for this quarter as they liquidated 10% of their inventory, Macy's would give me my money back in 4-5 years. 

 

I don't need Macy's to hit it out of the park.  I just need Macy's to keep up with its peer group.  If it can do that over the next couple of years, the market at some point will revalue it back up to around 10-12 times earnings.  And if they manage to get a double, then it might get valued at 13-15 times earnings. 

 

And what's the worst that could happen to Macy's in the next few years?  Another pandemic?  Tougher competition?  Reduced consumption?  They've plowed through all of that before.

 

I'm by no means saying people should sell Fairfax and buy Macy's.  25% of my portfolio is still Fairfax.  But I'm certainly comfortable buying a chunk of Macy's based on P/E and liquidation value.  I think it will return to fair value just like META did at some point.

 

Cheers!

[Viking]

The evolution of Fairfax - the multiple streams of high quality income phase

 

Last week in my long-form post we learned that Fairfax’s operating earnings have spiked to a much higher base level.

- https://thecobf.com/forum/topic/19861-fairfax-2023/page/45/#comment-528496

 

Let’s broaden the discussion out a little bit. Let’s look at all of Fairfax’s sources of income. What are they? What is their quality? How are they changing?

 

Why does sources of income matter?

 

‘Quality earnings’: of all the sources of income, operating income are generally considered to be the highest quality for P&C insurance companies because the sources are considered to be predictable and durable. Companies that generate the majority of their total earnings from operating income are considered to be higher quality. As a result, the the stock prices of these companies usually trade at a premium valuation to peers.

 

If we understand sources of income and their trend that should provide us with another important piece of information to help us understand a company’s valuation, especially when compared to peers.

 

Fairfax has 5 streams of income:

1. Underwriting profit
2. Interest and dividend income
3. Share of profit of associates (primarily Eurobank, Atlas, Exco, Stelco, GIG)
4. Non-insurance subsidiaries (primarily Recipe, Fairfax India, Thomas Cook, AGT, Grivalia Hospitality, Dexterra)
5. Net gains/losses on investments (mark to market equities, derivatives, fixed income, asset sales, including insurance)

The first three streams when added together give us all important operating income.

 

Let’s look at the average of these income streams over a 6-year period from 2016-2021 to see what we can learn:

 

Size: From 2016-2021, Fairfax generated in total an average of about $2.5 billion per year from the 5 income streams listed above. The total amount was quite volatile year-to-year.

 

Composition (split) of the average from 2016-2021:

• Net gains on investment was by far the largest income stream at 49% of the total.
• Interest and dividend income was the second largest bucket at 28%.
• Underwriting profit was the third largest largest at 12%.
• Share of profit of associates was 6%.
• Non-insurance subsidiaries was 4%.
• Operating income was a total of 46%, or less than half.

 

 

These splits fit the narrative of the company at the time (2016-2021):

 

The vast majority of income at Fairfax was being generated by ‘gains on investments’ and these gains had massive swings each year (up and down) so Fairfax’s reported results were quite volatile year to year. Lots of volatility year to year = low quality earnings.

 

From 2016-2021, Fairfax earned an average of $44/year. Book value averaged $474. Its stock traded around $500 during this time. Fairfax was valued at around 1.05 x BV and a PE of around 11.4. These multiples were well below peers.

 

Important: net gains/losses on investments - in the chart above an average number was input for each year from 2016-2021. Large negative annual numbers mess up the ‘split’ calculations. Importantly for our analysis, using an average number allows us to get a 6 year average that is a good representation of the split of the various income streams.

 

 

Let’s look at the income streams for 2022:

• We are going to look at 2022 on its own. 2022 was an anomalous year for global financial markets - we had the largest bear market in history in fixed income and, at the same time, a bear market in stocks. As a result, Fairfax had a $1.7 billion loss on investments in 2022. This was largely offset by a $1.2 billion gain from the sale of its pet insurance business (pre-tax). So the final loss on investments came in at only $514 million.
• Operating income spiked higher to $3.1 billion. This number on its own was now larger than the average of the total of all income sources from 2016-2021.

In 2022, the impact of rising interest rates has been fully reflected in Fairfax’s income statement and balance sheet. As a result, the fixed income portfolio/balance sheet has been largely de-risked from the impact of spiking interest rates.

 

At the same time, a significant shift in the composition of Fairfax’s income streams that started in 2021 accelerated in 2022 - each of the 3 components of operating income all increased to record levels in 2022.

 

Despite bear markets in both bond and stock markets, Fairfax was still able to deliver a total of $2.6 billion from its 5 income streams.

 

 

Let’s look at my estimates for the earnings streams for 2023-2025:

 

This is where things get really interesting. Especially when compared to 2016-2021.

 

Size: From 2023-2025, my estimate has Fairfax generating an average of $5.9 billion per year from the 5 income streams. This is an increase of 139% over the run rate of $2.5 billion from 2016-2021.

 

Composition (split) 2023-2025 compared to composition from 2016-2021:

• Interest income is now the largest single item at 36% up from 28%.
• Underwriting profit is up nicely to 21% from 12%.
• The big mover, though, is share of profit of associates which increased from 6 to 20%.
• Operating earnings are now 77% of the total. That is a massive increase from 46% from 2016-2021.
• Gains on investments are still a solid 20%. My estimate for this bucket of income is likely far too low - this is the one of the big reasons why I think my total earnings estimate for 2023-2025 will be proven to be too low.
• Non-insurance subsidiaries could grow significantly in the coming years. I think income of $400 million/year from this bucket (collection of companies) is attainable looking out a couple of years. Were this to occur, Fairfax would have a meaningful 5th income stream.

 

 

Conclusion:

 

Two stories are playing out simultaneously at Fairfax right now:

1. a total earnings story - earnings are spiking.
2. a quality of earnings story - the quality of earnings has improved dramatically in recent years

Importantly, the increases in both the size and quality of earnings is sustainable.

 

Having multiple sources of income does a couple of things for the company:

• provides important diversification across both insurance and investments.
• makes the whole company more resilient to both insurance and economic cycles.
• generates much more consistent cash flows over time allowing the company to be highly opportunistic with capital allocation.

This should make Fairfax a more valuable company. It should trade today at a valuation multiple more in line with peers (if not a premium to some).

 

 

What is reflected in Fairfax’s valuation?

 

Investors have been warming to the Fairfax story. The stock price has increased 145% over the past 31 months (since Dec 31, 2020). However, Fairfax currently trades at a 5.2 x multiple to my 2023 estimated earnings. It is also trading at about 1 x book value. These are very low multiples and much below peers.

 

This suggest to me that:

1. Mr. Market is starting to understand the spiking earnings story at Fairfax.
2. Mr Market does not yet understanding the much improved quality of earnings story at Fairfax.

And that is because multiple expansion has not yet happened at Fairfax. Mr Market does get things right over the medium term. My guess is as investors come to more fully understand ‘new Fairfax’ we will get multiple expansion in the coming years and Fairfax will trade at a multiple closer to peers. If this happens it would (along with continued growth in earnings and share buybacks) help power the price of the stock to much higher levels.

 

The hard market in insurance

 

There is a lot of hand wringing among investors today about the status of the hard market in insurance. When will it end? What will it mean for insurers? Do we get a sideways insurance market (not too hot or too cold)? Or do we a rapid descent into insurance hell - and a full-on soft market.

 

Underwriting profit makes up about 50% of total income for most insurers (with investments making up the other half - mostly from fixed income). So what happens to insurance pricing in the future will impact the financial results of most insurance companies in a significant way.

 

For Fairfax, as we have just learned above, underwriting profit only makes up about 20% of total income from expected sources. As a result, where insurance pricing goes in the future will impact Fairfax far less than its insurance peers.

 

Fairfax’s total earnings are now of a size, diversity and quality that maintaining strong underwriting profitability (perhaps mid-90’s CR) can be even more of the focus moving forward at the insurance operations. Unlike other insurance companies, Fairfax’s future will not be tied primarily to the insurance cycle. Its future will be tied to how well it does capital allocation. Capital allocation is increasingly becoming Fairfax’s competitive advantage.

 

The insurance business model used by Fairfax:

 

Fairfax uses the float of the insurance companies to buy non-insurance companies. These companies generate earnings. These earnings allow Fairfax to buy more insurance companies which increases float. This increase in float allows Fairfax to buy more non-insurance companies. Rinse and repeat…

 

As we have seen above, Fairfax is now generating a record amount of income from its 5 income streams. At the same times, the quality of income has never been better. As i stated in my post last week, through the flywheel effect, Fairfax has now achieved ‘breakthrough’.

 

My current estimate is Fairfax will generate a total of about $11.3 billion in net earnings (attributable to Fairfax shareholders) - mostly from high quality sources - over the next 3 years. Fairfax has never been better positioned as a company than it is today.

 

Fairfax has been trying to get to this exact place for 38 years. It has finally arrived. What we are witnessing in real time is the beginning of the next phase of Fairfax’s evolution as a company. It is reminiscent of a much younger Berkshire Hathaway. (Of course, Fairfax’s business model is uniquely its own.)

Edited August 25, 2023 by Viking

[UK]

1 hour ago, Parsad said:

 

At today's prices, if I liquidate FFH, even with higher fair value prices for the insurance subs, I might get 1-1.2 times book after paying off the debt...at best!

 

If I liquidated Macy's today, just the store in Herald Square alone is worth more than the entire company.  So forget the retail brick and mortar business, forget the online Macy's business, forget Bloomingdales, forget BlueMercury.  Just selling the real estate will pay off the debt and get me what the market value of the company is. 

 

Then if you look at it from a P/E basis...at current prices, I would get my money back from FFH in 8-10 years...whereas even with the lower earnings for this quarter as they liquidated 10% of their inventory, Macy's would give me my money back in 4-5 years. 

 

I don't need Macy's to hit it out of the park.  I just need Macy's to keep up with its peer group.  If it can do that over the next couple of years, the market at some point will revalue it back up to around 10-12 times earnings.  And if they manage to get a double, then it might get valued at 13-15 times earnings. 

 

And what's the worst that could happen to Macy's in the next few years?  Another pandemic?  Tougher competition?  Reduced consumption?  They've plowed through all of that before.

 

I'm by no means saying people should sell Fairfax and buy Macy's.  25% of my portfolio is still Fairfax.  But I'm certainly comfortable buying a chunk of Macy's based on P/E and liquidation value.  I think it will return to fair value just like META did at some point.

 

Cheers!

 

Thank you for the answer! I will try to read and think about this more.

 

But a. FFH is trading more like at 5-6 PE vs M at 4-5 next year earnings and I think that visibility of normalized earnings into next 2-3 years is much better at FFH? So isn't this valuation difference much smaller? b. to what could happen, well I do not anticipate this, but if there is a big recession or spending slowdown in the next 2-3 years, retail business could suffer (at least short term and btw M has more than 2x EBITDA net debt), while insurance (at least in terms of demand etc) would still be fine? 

 

And then, if you look at these two in terms of buy and forget, it is not even close? Meaning insurance as a business will hardly face any disruptions, here it is also operated by owner etc, while M is kinda the opposite, no?

 

Edited August 25, 2023 by UK

[Viking]

1 hour ago, Parsad said:

 

At today's prices, if I liquidate FFH, even with higher fair value prices for the insurance subs, I might get 1-1.2 times book after paying off the debt...at best!

 

If I liquidated Macy's today, just the store in Herald Square alone is worth more than the entire company.  So forget the retail brick and mortar business, forget the online Macy's business, forget Bloomingdales, forget BlueMercury.  Just selling the real estate will pay off the debt and get me what the market value of the company is. 

 

Then if you look at it from a P/E basis...at current prices, I would get my money back from FFH in 8-10 years...whereas even with the lower earnings for this quarter as they liquidated 10% of their inventory, Macy's would give me my money back in 4-5 years. 

 

I don't need Macy's to hit it out of the park.  I just need Macy's to keep up with its peer group.  If it can do that over the next couple of years, the market at some point will revalue it back up to around 10-12 times earnings.  And if they manage to get a double, then it might get valued at 13-15 times earnings. 

 

And what's the worst that could happen to Macy's in the next few years?  Another pandemic?  Tougher competition?  Reduced consumption?  They've plowed through all of that before.

 

I'm by no means saying people should sell Fairfax and buy Macy's.  25% of my portfolio is still Fairfax.  But I'm certainly comfortable buying a chunk of Macy's based on P/E and liquidation value.  I think it will return to fair value just like META did at some point.

 

Cheers!

Here is some constructive feedback:

1.) my guess is Fairfax earns $160/share in 2023. That is a 5.2 PE. I expect earnings per share to grow in 2024 and 2025. So Macy’s is not cheaper today.

2.) liquidation value. My guess is if Fairfax started to sell off its many assets it would realize significant value for shareholders. Of course that isn’t going to happen so it is kind of a useless exercise. My question: is Macy’s going to liquidate parts of the company?

3.) management: the management team at Fairfax has been executing exceptionally well the past 5 years (best in class among insurance companies). They are going to be getting in the range of another $11.3 billion in net earnings over the next 3 years. I have no idea how good the management team at Macy’s is… but are they that good?

4.) insurance is in a hard market. Retail is… in a terrible market that might get worse ( although i did buy a little Aritzia recently).

 

Sanjeev, my read is you are significantly underestimating the current earnings power of Fairfax - like many of the posters on this board. And i love it. Stocks usually climb the wall of worry.

 

PS: i will admit i do not follow Macy’s… but i will do some reading on the weekend. Your banging of the table is what got me back into Fairfax in late 2020. And more recently you nailed META.

 

Edited August 25, 2023 by Viking

[Candyman1]

Rumors of a take over bid on BB. Not sure how to think about it ... it seems after all the trials and tribulation with BB it would be nice to get money for BB and have it off the plate of FFH. On the other hand they seem to be making progress. Deep down, I think I would rather get rid of it. In the end it is now fairly small percentage of FFH.

[Parsad]

9 hours ago, Viking said:

Here is some constructive feedback:

1.) my guess is Fairfax earns $160/share in 2023. That is a 5.2 PE. I expect earnings per share to grow in 2024 and 2025. So Macy’s is not cheaper today.

2.) liquidation value. My guess is if Fairfax started to sell off its many assets it would realize significant value for shareholders. Of course that isn’t going to happen so it is kind of a useless exercise. My question: is Macy’s going to liquidate parts of the company?

3.) management: the management team at Fairfax has been executing exceptionally well the past 5 years (best in class among insurance companies). They are going to be getting in the range of another $11.3 billion in net earnings over the next 3 years. I have no idea how good the management team at Macy’s is… but are they that good?

4.) insurance is in a hard market. Retail is… in a terrible market that might get worse ( although i did buy a little Aritzia recently).

 

Sanjeev, my read is you are significantly underestimating the current earnings power of Fairfax - like many of the posters on this board. And i love it. Stocks usually climb the wall of worry.

 

PS: i will admit i do not follow Macy’s… but i will do some reading on the weekend. Your banging of the table is what got me back into Fairfax in late 2020. And more recently you nailed META.

 

 

10 hours ago, UK said:

 

Thank you for the answer! I will try to read and think about this more.

 

But a. FFH is trading more like at 5-6 PE vs M at 4-5 next year earnings and I think that visibility of normalized earnings into next 2-3 years is much better at FFH? So isn't this valuation difference much smaller? b. to what could happen, well I do not anticipate this, but if there is a big recession or spending slowdown in the next 2-3 years, retail business could suffer (at least short term and btw M has more than 2x EBITDA net debt), while insurance (at least in terms of demand etc) would still be fine? 

 

And then, if you look at these two in terms of buy and forget, it is not even close? Meaning insurance as a business will hardly face any disruptions, here it is also operated by owner etc, while M is kinda the opposite, no?

 

 

Macy's could experience a recessionary environment, but so will the entire retail industry.  The question is why is Macy's priced at a lower valuation to its peers...not dissimilarly to why FFH is priced lower to its peers?  

 

For some reason, the market thinks both Macy's and FFH will disproportionately be impacted by any industry losses, so Macy's is dumped in with lower tier retailers and FFH is dumped in partly with general reinsurers.  

 

Yet neither business deserves to belong there.  Like FFH is currently doing, Macy's has generated steady free cash for years, unlike many retail competitors.  Macy's also owns a quality real estate portfolio.  Again like Fairfax, Macy's has been through many different types of environments and continues to generate cash.

 

So even in the best case scenario, you've both assumed that Macy's isn't priced any more cheaply than Fairfax...yet we would all agree that as Macy's goes down and Fairfax goes up, the margin of safety moves in favor of Macy's. 

 

Like I said, I own a ton of Fairfax, and I like its long-term prospects.  But I find Macy's more and more attractive as the price falls further.  The one thing I promised myself years ago, is never fall in love with a stock...fall in love with the fundamentals and the margin of safety it provides.  If something is cheap and something is stupid cheap...I'm going to always fall into that stupid cheap category!  Cheers!